Imagine this scenario. Bankers and Mortgage Brokers have gone berserk writing mortgages for people who could not afford to pay them off. Some customers didn’t even make the first payment. Some signatures were forged to get approval. It was an era of pure “greed.” Now, imagine this fictitious conservation between two bankers: “Tom, you know we have a lot of junk here with some of these mortgages.” “Yes, says Bill. Why don’t we just package them together and resell them to hedge funds and pension funds? We’ll use a fancy name like Collateralized Debt Obligations. That way no one will know exactly what we are selling them.” This scheme goes along for a while until a few “sane” investors start thinking: “I don’t think we should buy this stuff.” There are no bids and the market freezes up. Panic sets in and the markets are in freefall. The bankers run to the politicians and beg, hat in hand, for a bailout from Congress. The politicians dream up a fancy name like TARP and give the bankers $787 billion of taxpayer money. However, this is just a drop in the bucket. A whopping $7 trillion of household debt has been wiped out.
Enter the US Federal Reserve. Here again, Chairman Ben Bernanke and Fed policy makers dream up a fancy name called Quantitative Easing or QE for short. The plan is simple. The Fed buys long- term bonds and mortgage- backed securities and gives the bankers $4.45 trillion over the next nearly six years. (When the Fed buys bonds it credits the banks’ balance sheets.) It also drops the Fed Funds near zero. This massive giveaway lasted from 2009 until it ended in October 2014.
Now the bankers are back in business, big time. They speculate in the markets and drive the Dow Jones Industrial Average to all time highs. Not only that. The excess reserves are parked at the Fed and the Fed pays them interest on this money. It is a win-win situation.
However there was a fatal flaw in plan. Money flowed into the stock market and the rest is sitting at the Fed drawing interest. Former Chairman, Alan Greenspan, pointed out that QE did have a “major effect” on price to earnings ratios, capitalization rates in real estate and all income earning assets by lowering interest rates. However, Greenspan pointed out that there was no real demand in the real economy. Bernanke never insisted that the banks lend out this money to stimulate real economic growth. This has left Main Street in a weakened position. At present, the economy is humming along quite nicely. How long it will last is anyone’s guess.
The other big economies, Europe, China and Japan, all are floundering. Europe’s banking system is being tested as to whether or not EU countries can repay their bondholders. The EU Commission has started a QE program of its own. Japan embarked on a massive stimulus program, but is yet to see positive results. In China, real estate prices are under pressure and are expected to drop by 10%.
It looks like the US Fed is shooting dice, hoping that the rest of the world will gather steam and keep the overall world economy expanding. It’s anyone’s guess how this will all play out.
The good news is that GDP for Q3 was at a 3.5% annual rate. Who knows? Given a few more quarters of this growth and we could see the Dow Jones Industrial Average climb to 19,000.